Cite this article
Gordon, E.A., Henry, E., Jorgensen, B.N. et al. Flexibility in cash-flow classification under IFRS: determinants and consequences. Rev Account Stud 22, 839–872 (2017).
Share this article
We initially document variation in classification choices within a hand-collected sample of 798 nonfinancial IFRS firms in 13 European countries from 2005 to 2012. About 76, 60, and 57% of the sample classifies interest paid, interest https://paydayloanstennessee.com/cities/dyersburg/ received, and dividends received, respectively, in OCF. Only about 42% of the sample firms that report all three items opt to classify all three in OCF. We document significant variation in classification across industries and most countries.
Variation in classification of cash flow items also introduces noncomparability into measurement of widely used metrics, such as accruals and free cash flow. Footnote 6 Therefore the final set of analyses focuses on consequences of flexibility in classification choice. The first consequence we examine pertains to the market pricing of persistence of cash flows and accruals. We examine whether the persistence of cash flows and accruals differs for firms that report consistent with U.S. GAAP, compared to those making classification choices permitted under IFRS. We find some evidence of differences in accrual pricing between the group of firms reporting consistent with U.S. GAAP and those using the classification flexibility allowed under IFRS, but results are sensitive to model specification.
We predict that firms with contracting concerns and costs involved in renegotiating debt covenants will also seek to report higher OCF. Our proxy for contracting concerns is leverage, computed as total liabilities divided by total assets. We predict a positive relation.
= one if the firm’s ratio of total liabilities over total assets at the beginning of the fiscal year, averaged over the sample period, is greater than the median and zero otherwise;
= the amount of accruals, calculated as net income less reported operating cash flows for year t divided by average of total assets for year t;
Description of classification choices
The financial statement effects of cash flow classification choices are reflected in a comparison of reported OCF and pro-forma U.S. GAAP OCF. Specifically, we test whether the operating, investing, and financing cash flows as reported would differ significantly from cash flows under U.S. GAAP classifications. We adjust as-reported OCF to include interest paid, interest received, and dividends received. Similarly, we adjust as-reported investing and financing cash flows to exclude these items. Footnote 23 Table 5 reports descriptive statistics of the as-reported cash flows and the pro forma U.S. GAAP cash flows. Footnote 24 The mean (median) of reported OCF is about 2.4% (3.5%) higher than it would have been under U.S. GAAP, Footnote 25 while financing cash flows are lower. Reported investing cash flow is also higher than it would have been under U.S. GAAP, reflective of instances in which interest received, dividends, or both received are reported as investing inflows (which is not allowed under U.S. GAAP). Means and medians of OCF, investing cash flows, and financing cash flows in the pooled sample differ significantly between as-reported amounts and pro forma U.S. GAAP amounts. Means of the pair-wise differences are significantly different for all cash flow components.
The various classification changes impact reported operating cash flow differently. To examine determinants of classification choice, we therefore focus only on the 57 firms that increased OCF by making the classification change. We compare the OCF-increasing changers to a control group of firms that did not make an OCF-increasing classification change and specifically nonchanging firms with existing classification choices that have not already maximized reported OCF. (OCF would be maximized by excluding interest paid from operating while including both interest received and dividends received in operating.) Thus we include the nonchanging firms facing a similar decision as the OCF-enhancing changers; that is, they face the possibility of increasing reported OCF by making a change in classification. This restriction left 109 firms, all of which are included as a control sample.
The implications of the market-implied coefficients, however, differ for the two groups. The FLEX subsample’s market-implied persistence of accruals (0.2325) is much lower than the persistence parameter (0.4302), and the market-implied persistence of cash flow (0.1922) is also much lower than the persistence parameter (0.6788), indicating underpricing of both components. Footnote 29 (Pincus et al. (2007) similarly find underweighting of both accruals and operating cash flows in four of the countries they study, two of which are European.) However, the FLEX subsample’s market-implied persistence of accruals (0.2325) exceeds the market-implied persistence of operating cash flow (0.1922), indicating a higher pricing for accruals relative to cash flow.
Using an international setting, we build on and extend certain findings from the U.S.-only setting of Lee (2012). We find that firms with a higher likelihood of financial distress as well as those that issue more equity, have higher leverage, and are less profitable are more likely to make OCF-increasing classification choices. Our findings further suggest that cross-listed firms tend to make classification choices consistent with U.S. GAAP. Firms are more likely to make OCF-increasing classification changes when they have issued equity and less likely to change when they are followed by analysts, have more peers making similar choices, and are cross-listed in the U.S. Overall, OCF-enhancing classification choices are associated with both financial and informational factors.
